Question

1. Assume that XYZ corporation decided to simultaneously issue $40 million of straight bonds with a coupon rate of 14 percent and $40 million of convertible bonds with a coupon rate of 12 percent. Both bonds have the same maturity.

   1. Does the fact that the convertible issue has the lower coupon rate suggest that it is less risky than the straight bond? Explain.

   2. Is the cost of capital lower on the convertible than on the straight bond? Explain.

Answer 1

1. Convertible Bonds are better than Straight Bonds and shares the similar risk at same coupon rate,as it typically offers a better return than a traditional bond without the added risk of the stock market.

   In this case, the Convertible Bonds are at lower coupon rate than Straight Bonds, so less risky for the issuer, as all other parameters are constant for both the types of bonds.

   Convertible bonds have higher yield as compared to straight bonds, due to its additive equity features, as it is a hybrid security, that means, convertible bonds have both debt and Equity like features. According to Kiplinger, the return on convertible Bond generally falls between that of bonds and stocks. The high return of convertible bonds comes from the earnings investors gain when the company stock price rises and they trade their bond in for shares of stock. It also comes from the dividends associated with those shares.

2. If the convertible bond replaces senior debt, then the company’s interest expense falls, the tax shield falls, and WACC rises.

• If the convertible bond is subordinated to the firm’s senior debt, then the yield on the remaining senior debt should slightly fall, which further decreases interest expense and tax shield, further increasing WACC.

• Cost of equity (for the existing common shares) should be unchanged (except for a small secondary effect, where the reduced tax shield slightly reduces market capitalization)

• WACC=[W_d*K_d(1-t)]+W_e*K_e

Where, K_d=Cost of Debt K_e=Cost of Equity W_d=Weight of Debt W_e=Weight of Equity t=tax rate

• This tells that Cost of Capital is higher on Convertible Bonds as compared to straight Bonds.